FINC 318 Chapter 1 Flashcards

Overview of Financial Management

Introduction

This document provides an overview of financial management, focusing on its key areas, decisions made by financial managers, the goals of financial management, and the structure of various business organizations. The insights provided by Dr. Ming Ju will guide students’ understanding of the essential concepts in Business Finance (FINC 318).

Areas of Finance

Finance is the art and science of managing wealth, encompassing several distinct yet interrelated areas:

1. Financial Management (Corporate Finance)This area of finance focuses on key decisions related to asset acquisition, capital raising, and operational management to enhance the firm's value.

2. InvestmentsThis involves decisions regarding stocks and bonds, which include activities such as:

   • Security Analysis: Determining the correct values for individual securities.

   • Portfolio Theory: Establishing optimal portfolio structures.

   • Market Analysis: Evaluating whether market conditions indicate overvaluation or undervaluation.

3. Capital MarketsThese are platforms for issuing and trading long-term securities like stocks and bonds, integral for capital raising and resource allocation. Key players include:

   • Commercial banks

   • Investment banks

   • Insurance companies

   • Mutual and pension funds

4. International FinanceThis encompasses financial activities across borders, addressing issues such as foreign exchange risks and international monetary systems.

Financial Management Decisions

Financial management involves critical decision-making in various areas:

• Capital Budgeting: Decisions related to long-term investment opportunities.

• Working Capital Management: Ensuring the firm can maintain operating liquidity.

• Cost of Capital: Determining the appropriate financing mix.

• Financing Decisions: Understanding how to structure capital efficiently.

• Capital Structure Decisions: Strategies on the mix of equity, debt, and other financing.

• Dividend Decisions: Policies regarding profits distribution, including retained earnings and levers for reinvestment.

Goals of Financial Management

Understanding Stakeholder Interests

Managers primarily work for shareholders, who aim to maximize their wealth. The formula for shareholder wealth is:

Wealth = Number of Shares Owned × Stock Price per ShareFor example, if a shareholder owns 150 shares at $25 each, their wealth is calculated as 150 × 25 = $3,750.The overarching goal of financial management is to maximize this wealth by increasing the company's stock price over the long term, which reflects its intrinsic value.

Market Price and Intrinsic Value

• Intrinsic Value: Represents the fundamental value of a stock based on risk and return data.

• Market Price: The value determined by stock market investors. Stocks can be priced either above (overvalued) or below (undervalued) their intrinsic value.

Agency Problem

Understanding the Relationship

The agency problem arises from the dynamics between shareholders (principals) and company managers (agents). Here, conflicts of interest may lead managers to prioritize personal agendas over shareholder interests.

Solutions to Mitigate Agency Problems

1. Compensation Incentives: Aligning managerial compensation with shareholder value through reasonable packages tied to long-term performance (e.g., stock options).

2. Direct Shareholder Intervention: Institutional investors can exert influence, notably in cases of poor performance leading to CEO removals across various companies (e.g., Under Armour, eBay).

3. Threat of Hostile Takeovers: Companies with undervalued stock become acquisition targets, prompting management to maintain stock health.

Aligning Interests Proposal Evaluation

In evaluating different managerial compensation proposals, aligning interests is crucial. For instance, a compensation plan featuring stock options that vest over multiple years encourages long-term value creation over heftier immediate salaries and perks.

Forms of Business Organizations

Common Structures

1. Sole Proprietorship

   • Advantages: Simplest to start, less regulation, all profits go to owner, lower taxes.

   • Disadvantages: Unlimited liability, limited lifespan to owner’s life, equity capital limited.

2. Partnership

   • Advantages: Easier startup, taxed as individuals.

   • Disadvantages: Unlimited personal liability, limited capital raising capabilities, dissolution upon death of a partner.

3. Corporation

   • Advantages: Ability to raise capital, unlimited life, limited liability for owners.

   • Disadvantages: Agency problems due to ownership and management separation, double taxation on income.

4. Limited Liability Companies (LLC) and Limited Liability Partnerships (LLP)

   • Combining elements of corporations and partnerships; these structures protect owners from liabilities beyond their investments and allow tax to pass through to individual members.